Accounting 201 Exam 3 Study Guide
Accounting 201 Exam 3 Study Guide ACCT 201
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This 10 page Study Guide was uploaded by George Maxwell Miller on Wednesday March 23, 2016. The Study Guide belongs to ACCT 201 at University of Louisville taught by Johnston in Spring 2016. Since its upload, it has received 64 views. For similar materials see Intro to Accounting 1 in Accounting at University of Louisville.
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Date Created: 03/23/16
STUDY GUIDE Exam #3 (Chapters 7-9) Exam #3 consists of 40 multiple choice questions evenly distributed among chapters 7-9. The exam will mainly cover the topics covered in the homework, in class work, and in class discussions. No ratios are on the exam. No information from any appendix is on the exam. Questions on the exam may include the following topics: Chapter 7 (approx 38% theory; 62% calculations and/or journal entries) % of accounts receivable method Total estimated Bad Debts Expense – Previous Balance in Allowance Account = Current Bad Debts Expense Year-end Accounts Receivable x Bad Debt % Aging accounts receivable method o The aging of accounts receivable method uses past and current receivables to estimate the allowance amount. Specifically, each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is to be uncollectible. Classifications are often based on 30-day periods. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percent’s are applied to the amounts in each class and then totaled to get the estimated balance of the Allowance for Doubtful Accounts. Direct write-off method • The direct write-off method of accounting for bad debts records the loss from an uncollectible account receivable when it is determined to be uncollectible. No attempt is made to predict bad debts expense. o Example, Bobs fish market determines that on January 27, it cannot collect the $680 owed to it by its customer M. Miller. Therefore, it debits “Bad Debts Expense” 680 dollars and credits “Accounts receivable—M. Miller” 680 dollars to write off an uncollectible account. o To reinstate the account after it was previously written off, you would debit “Cash” 680 dollars and credit “Accounts Receivable—M. Miller” by 680 dollars, showing the account has been paid in full. The allowance method of accounting for bad debts matches the estimated loss from uncollectible accounts receivable against the sales they helped produce. We must use estimated losses. This means that at the end of each period, the allowance method requires an estimate of the total bad debts expected to result from that period’s sales. This method has two advantages over the direct write-off method: (1) It records estimated bad debts expense in the period when the related sales are recorded and (2) it reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. Notes receivable (calculation of interest, maturity date, maturity value, journal entries, etc.) o A promissory note is a written promise to pay a specified amount of money, usually with interest, either on demand or at a definite future date. Promissory notes are used in many transactions, including paying for products and services, and lending and borrowing money. Sellers sometimes ask for a note to replace an account receivable when a customer requests additional time to pay a past-due account. For legal reasons, sellers generally prefer to receive notes when the credit period is long and when the receivable is for a large amount. If a lawsuit is needed to collect from a customer, a note is the buyer’s written acknowledgment of the debt, its amount, and its terms. o The maturity date of a note is the day the note (principal and interest) must be repaid. The period of a note is the time from the note’s (contract) date to its maturity date. Many notes mature in less than a full year, and the period they cover is often expressed in days. When the time of a note is expressed in days, its maturity date is the specified number of days after the note’s date. As an example, a five-day note dated June 15 matures and is due on June 20. A 90-day note dated July 10 matures on October 8. This October 8 due dates is computed as shown in this slide. The period of a note is sometimes expressed in months or years. When months are used, the note matures and is payable in the month of its maturity on the same day of the month as its original date. A nine- month note dated July 10, for instance, is payable on April 10. The same analysis applies when years are used. o Interest is the cost of borrowing money for the borrower or, alternatively, the profit from lending money for the lender. Unless otherwise stated, the rate of interest on a note is the rate charged for the use of the principal for one year. The formula for computing interest on a note is shown in the slide. It is calculated as Principal times Rate times Time. Matching, full disclosure, and materiality principles • The matching (expense recognition) principle requires expenses to be reported in the same accounting period as the sales they helped produce. This means that if extending credit to customers helped produce sales, the bad debts expense linked to those sales is matched and reported in the same period. The direct write-off method usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which often occurs in a period after that of the credit sale. To match bad debts expense with the sales it produces therefore requires a company to estimate future uncollectibles. • The materiality constraint states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. The materiality constraint permits the use of the direct write-off method when bad debts expenses are very small in relation to a company’s other financial statement items such as sales and net income. Chapter 8 (approx 54% theory; 46% calculations and/or journal entries) Different methods of calculating depreciation o Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Depreciation does not measure the decline in the asset’s market value each period, nor does it measure the asset’s physical deterioration. Since depreciation reflects the cost of using a plant asset, depreciation charges are only recorded when the asset is actually in service. o Factors that determine depreciation are (1) cost, (2) salvage value, and (3) useful life. o Cost - The cost of a plant asset consists of all necessary and reasonable expenditures to acquire it and to prepare it for its intended use. o Salvage Value - The total amount of depreciation to be charged off over an asset’s benefit period equals the asset’s cost minus its salvage value. Salvage value, also called residual value or scrap value, is an estimate of the asset’s value at the end of its benefit period. This is the amount the owner expects to receive from disposing of the asset at the end of its benefit period. If the asset is expected to be traded in on a new asset, its salvage value is the expected trade-in value. o Useful Life - The useful life of a plant asset is the length of time it is productively used in a company’s operations. Useful life, also called service life, might not be as long as the asset’s total productive life. For example, the productive life of a computer can be eight years or more. Some companies, however, trade in old computers for new ones every two years. In this case, these computers have a two-year useful life, meaning the cost of these computers (less their expected trade-in values) is charged to depreciation expense over a two-year period. o Straight-line depreciation charges the same amount of expense to each period of the asset’s useful life. A two-step process is used. We first compute the depreciable cost of the asset, also called the cost to be depreciated. It is computed by subtracting the asset’s salvage value from its total cost. Second, depreciable cost is divided by the number of accounting periods in the asset’s useful life. o If this machine is purchased on December 31, 2014, and used throughout its predicted useful life of five years, the straight-line method allocates an equal amount of depreciation to each of the years 2015 through 2019. We make the adjusting entry at the end of each of the five years to record straight-line depreciation of this machine. o The $1,800 Depreciation Expense is reported on the income statement among operating expenses. The $1,800 Accumulated Depreciation is a contra asset account to the Machinery account in the balance sheet. o When equipment use varies from period to period, the units-of- production depreciation method can better match expenses with revenues. Units-of-production depreciation charges a varying amount to expense for each period of an asset’s useful life depending on its usage. o A two-step process is used to compute units-of-production depreciation. We first compute depreciation per unit by subtracting the asset’s salvage value from its total cost and then dividing by the total number of units expected to be produced during its useful life. Units of production can be expressed in product or other units such as hours used or miles driven. The second step is to compute depreciation expense for the period by multiplying the units produced in the period by the depreciation per unit. o An accelerated depreciation method yields larger depreciation expenses in the early years of an asset’s life and less depreciation in later years. The most common accelerated method is the declining-balance method of depreciation, which uses a depreciation rate that is a multiple of the straight-line rate and applies it to the asset’s beginning- of-period book value. The amount of depreciation declines each period because book value declines each period. Gain/loss on disposal of a plant asset o Plant assets are disposed of for several reasons. Some are discarded because they wear out or become obsolete. Others are sold because of changing business plans. Regardless of the reason, disposals of plant assets occur in one of three basic ways: discarding, sale, or exchange. o After we dispose of a plant asset, the first thing we do is update depreciation to the date of disposal. After completing the update, we can prepare the journal entry. We do so by recording a debit to the cash account, if cash was received, or credit the cash account, if cash was paid by the company. In addition, we must determine whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account. We complete the entry by removing the plant asset’s cost from our books with a credit, and remove the related accumulated depreciation with a debit. o If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. o If the cash received is less than the book value of the asset, a loss will be recorded. o When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Capital expenditures and revenue expenditures o Revenue expenditures, also called income statement expenditures, are additional costs of plant assets that do not materially increase the asset’s life or productive capabilities. They are recorded as expenses and deducted from revenues in the current period’s income statement. Examples of revenue expenditures are cleaning, repainting, adjustments, and lubricants. o Capital expenditures, also called balance sheet expenditures, are additional costs of plant assets that provide benefits extending beyond the current period. They are debited to asset accounts and reported on the balance sheet. Capital expenditures increase or improve the type or amount of service an asset provides. Examples are roofing replacement, plant expansion, and major overhauls of machinery and equipment. o After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. In recording these expenditures, it must decide whether to capitalize or expense them (to capitalize an expenditure is to debit the asset account). The issue is whether these expenditures are reported as current period expenses or added to the plant asset’s cost and depreciated over its remaining useful life. o One way to handle these types of expenditures is to treat them as a capital expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In most cases, the capital expenditure represents an additional cost of plant assets that provide benefits extending beyond the current period. In some cases, the expenditures may be treated as revenue expenditure and charged to current period income as an expense. For each expenditure, subsequent to acquisition of a plant asset, we must decide if the expenditure is to be treated as capital or revenue expenditure. o Ordinary repairs are expenditures to keep an asset in normal, good operating condition. They are necessary if an asset is to perform to expectations over its useful life. Ordinary repairs do not extend an asset’s useful life beyond its original estimate or increase its productivity beyond original expectations. Examples are normal costs of cleaning, lubricating, adjusting, oil changing, and replacing small parts of a machine. Ordinary repairs are treated as revenue expenditures. This means their costs are reported as expenses on the current-period income statement. Accounting for betterments and extraordinary repairs is similar—both are treated as capital expenditures. o Betterments (Improvements) Betterments, also called improvements, are expenditures that make a plant asset more efficient or productive. A betterment often involves adding a component to an asset or replacing one of its old components with a better one and does not always increase an asset’s useful life. An example is replacing manual controls on a machine with automatic controls. One special type of betterment is an addition, such as adding a new wing or dock to a warehouse. Since a betterment benefits future periods, it is debited to the asset account as a capital expenditure. The new book value (less salvage value) is then depreciated over the asset’s remaining useful life. o Extraordinary repairs are expenditures extending the asset’s useful life beyond its original estimate. Extraordinary repairs are capital expenditures because they benefit future periods. Their costs are debited to the asset account (or to accumulated depreciation). Cost of an asset o Plant assets are recorded at cost when acquired. This is consistent with the cost principle. Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. The cost of a factory machine, for instance, includes its invoice cost less any cash discount for early payment, plus any necessary freight, unpacking, assembling, installing, and testing costs. Examples are the costs of building a base or foundation for a machine, providing electrical hookups, and testing the asset before using it in operations. o Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. o The costs of machinery and equipment consist of all costs normal and necessary to purchase them and prepare them for their intended use. These include the purchase price, taxes, transportation charges, insurance while in transit, and the installing, assembling, and testing of the machinery and equipment. o A Building account is charged for the costs of purchasing or constructing a building that is used in operations. When purchased, a building’s costs usually include its purchase price, brokerage fees, taxes, title fees, and attorney fees. Its costs also include all expenditures to ready it for its intended use, including any necessary repairs or renovations such as wiring, lighting, flooring, and wall coverings. o When a company constructs a building or any plant asset for its own use, its costs include materials and labor plus a reasonable amount of indirect overhead cost. Overhead includes the costs of items such as heat, lighting, power, and depreciation on machinery used to construct the asset. Costs of construction also include design fees, building permits, and insurance during construction. o Land improvements are additions to land and have limited useful lives. Examples are parking lot surfaces, driveways, walkways, fences, landscaping, and sprinkling and lighting systems. Costs of land improvements include expenditures necessary to make those improvements ready for their intended use. While the costs of these improvements increase the usefulness of the land, they are charged to a separate Land Improvement account so that their costs can be allocated to the periods they benefit. Natural resources (identification & depletion) o Natural resources are recorded at cost, which includes all expenditures necessary to acquire the resource and prepare it for its intended use. Depletion is the process of allocating the cost of a natural resource to the period when it is consumed. Natural resources are reported on the balance sheet at cost less accumulated depletion. The depletion expense per period is usually based on units extracted from cutting, mining, or pumping. This is similar to units-of-production depreciation. o Example, Let’s consider a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000, and we expect zero salvage value. The depletion charge per ton of ore mined is $2, computed as $500,000/250,000 tons. If 85,000 tons are mined and sold in the first year, the depletion charge for that year is $170,000. § If the company extracts and sells 85,000 tons during the year, depletion expense will be $170,000 (85,000 tons times $2 per ton). The journal entry to record depletion is to debit Depletion Expense – Mineral Deposit for $170,000, and credit Accumulated Depletion – Mineral Deposit for the same amount. • The period-end balance sheet reports the mineral deposit as shown in this slide. Since all 85,000 tons of the mined ore are sold during the year, the entire $170,000 of depletion is reported on the income statement. If some of the ore remains unsold at year-end, however, the depletion related to the unsold ore is carried forward on the balance sheet and reported as Ore Inventory, a current asset. Intangible assets (identification & amortization) o Intangible assets are nonphysical assets (used in operations) that confer on their owner’s long- term rights, privileges, or competitive advantages. Examples are patents, copyrights, licenses, leaseholds, franchises, goodwill, and trademarks. Lack of physical substance does not necessarily imply an intangible asset. Notes and accounts receivable, for instance, lack physical substance, but they are not intangibles. o An intangible asset is recorded at cost when purchased. Intangibles are then separated into those with limited lives or indefinite lives. If an intangible has a limited life, its cost is systematically allocated to expense over its estimated useful life through the process of amortization. If an intangible asset has an indefinite life—meaning that no legal, regulatory, contractual, competitive, economic, or other factors limit its useful life—it should not be amortized. (If an intangible with an indefinite life is later judged to have a limited life, it is amortized over that limited life.) Chapter 9 (approx 57% theory; 43% calculations and/or journal entries) Types of liabilities, characteristics, classifications, entries, etc. o A liability is a probable future payment of assets or services that a company is presently obligated to make as a result of past transactions or events. This definition includes three crucial factors: o A past transaction or event. o A present obligation. o A future payment of assets or services. o Current liabilities, also called short-term liabilities, are obligations due within one year or the company’s operating cycle, whichever is longer. They are expected to be paid using current assets or by creating other current liabilities. Common examples of current liabilities are accounts payable, short-term notes payable, wages payable, warranty liabilities, lease liabilities, taxes payable, and unearned revenues. o A company’s obligations not expected to be paid within the longer of one year or the company’s operating cycle are reported as long-term liabilities. They can include long- term notes payable, warranty liabilities, lease liabilities, and bonds payable. They are sometimes reported on the balance sheet in a single long-term liabilities total or in multiple categories. Accrual of interest o Interest that builds over the course of time. For example, on December 31, we accrue the interest for the number of days between November 25 and December 31. There are five days remaining in November plus 31 days in December; a total of 36 days. We record 36 days of interest expense; $8,000 multiplied by 5% multiplied by 36/360 is $40 of accrued interest, and we credit Interest payable. Payroll taxes (employee and employer) o An employer incurs several expenses and liabilities from having employees. These expenses and liabilities are often large and arise from salaries and wages earned, from employee benefits, and from payroll taxes levied on the employer. o Gross pay is the total compensation an employee earns including wages, salaries, commissions, bonuses, and any compensation earned before deductions such as taxes. (Wages usually refer to payments to employees at an hourly rate. Salaries usually refer to payments to employees at a monthly or yearly rate.) Net pay, also called take-home pay, is gross pay less all deductions. Payroll deductions, commonly called withholdings, are amounts withheld from an employee’s gross pay, either required or voluntary. Required deductions result from laws and include income taxes and Social Security taxes. Voluntary deductions, at an employee’s option, include pension and health contributions, health and life insurance premiums, union dues, and charitable giving. o The federal Social Security system provides retirement, disability, survivorship, and medical benefits to qualified workers. Laws require employers to withhold Federal Insurance Contributions Act (FICA) taxes from employees’ pay to cover costs of the system. Employers usually separate FICA taxes into two groups: (1) retirement, disability, and survivorship and (2) medical. For the first group, the Social Security system provides monthly cash payments to qualified retired workers for the rest of their lives. These payments are often called Social Security benefits. Taxes related to this group are often called Social Security taxes. For the second group, the system provides monthly payments to deceased workers’ surviving families and to disabled workers who qualify for assistance. These payments are commonly called Medicare benefits; like those in the first group, they are paid with Medicare taxes (part of FICA taxes). o The federal government participates with states in a joint federal and state unemployment insurance program. Each state administers its program. These programs provide unemployment benefits to qualified workers. The federal government approves state programs and pays a portion of their administrative expenses. o Federal Unemployment Tax Act (FUTA). Employers are subject to a federal unemployment tax on wages and salaries paid to their employees. For the recent year, employers were required to pay FUTA taxes of as much as 6.0% of the first $7,000 earned by each employee. This federal tax can be reduced by a credit of up to 5.4% for taxes paid to a state program. As a result, the net federal unemployment tax is often only 0.6%. o State Unemployment Tax Act (SUTA). All states support their unemployment insurance programs by placing a payroll tax on employers. (A few states require employees to make a contribution. In the book’s assignments, we assume that this tax is only on the employer.) In most states, the base rate for SUTA taxes is 5.4% of the first $7,000 paid each employee. This base rate is adjusted according to an employer’s merit rating. The state assigns a merit rating that reflects a company’s stability or instability in employing workers. A good rating reflects stability in employment and means an employer can pay less than the 5.4% base rate. A low rating reflects high turnover or seasonal hirings and layoffs.
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